Study Notes on Exchange Traded Funds (ETFs) for FIN 2062

Canadian Investments II: Exchange Traded Funds (ETFs)

Course Information

• Instructor: Robert Symmons, Professor

• School: School of Accounting and Finance

• Course Code: FIN 2062

• Term: Fall 2025

• Course Description: Canadian Securities Course Volume 2

• Chapter Overview

  • Chapter 19 focuses on Exchange Traded Funds (ETFs).

  • The chapter is divided into key sections covering:

  • Regulation and Key Features

  • Types and Risks of ETFs

  • Mutual Fund Comparison and Taxation

  • Investment Strategies and Related Products

Chapter Structure

• Part 1: Regulation and Structure of ETFs

• Part 2: Key Features of ETFs

• Part 3: Various Types of ETFs

• Part 4: Risks of Investing in ETFs

• Part 5: Comparing ETFs and Mutual Funds

• Part 6: Taxation of Investors in ETFs

• Part 7: Investment Strategies Using ETFs

• Part 8: Other Related Products

Introduction

• Definition of ETF:

  • An ETF is a professionally managed investment vehicle that combines features of mutual funds and individual stocks.

  • Structure:

  • Structured as an open-end mutual fund trust and regulated like mutual funds.

  • Most ETFs are passively managed, tracking a particular index (e.g., S&P 500).

  • An increasing number of ETFs are actively managed.

  • Trading Characteristics:

  • ETFs trade on an exchange, allowing transactions on margin or short-selling.

Part 1: Regulation and Structure

• Regulatory Framework:

  • Subject to National Instruments:

  • 81-102 (Mutual Funds)

  • 81-104 (Commodities and Derivatives)

  • 41-101 (Disclosure for Distribution)

  • ETF Facts Document:

  • Similar to Fund Facts document for mutual funds.

  • Includes trading and pricing characteristics, such as bid-ask spread and premium/discount to NAV.

  • Investors can seek damages or rescind purchase if the document is not provided.

Creation and Redemption Process

• ETFs are created or redeemed in blocks of units (e.g., 25,000).

• Designated Broker's Role:

  • Works with ETF provider to launch new funds.

  • Buys shares in the index the ETF tracks.

  • In-kind exchange: delivers a basket of shares to the ETF provider for a prescribed number of units.

Cost Structure

• Designated brokers pay the trading costs associated with underlying shares.

• Earnings are derived from the bid-ask spread, leading to lower trading costs overall.

• Trading costs for a single buyer or seller are directly incurred via the bid/ask spread and trading commissions.

• ETFs as open-end funds possess unlimited supply to meet demand.

Part 2: Key Features of ETFs

• Cost Efficiency:

  • Cheaper than index funds due to administrative costs being borne by the dealer, unlike mutual funds.

  • Mutual funds incur costs when buying/selling shares to meet fund flows, while ETFs utilize in-kind processes.

• Tradability and Liquidity:

  • ETFs can be traded anytime when markets are open.

  • Can be held on margin, shorted, and options can be traded on them.

  • Market, limit, or stop orders can be placed.

  • True liquidity is indicated by the trading volume of underlying shares.

• Tracking Error:

  • ETFs have lower tracking errors compared to index funds due to lower administrative and trading costs.

  • The in-kind creation/redemption process closely aligns ETFs' market price with NAV.

• Tax Efficiency:

  • Low portfolio turnover results in fewer realizations of capital gains.

• Transparency:

  • Index ETFs publish their holdings daily, enhancing investor knowledge and decision-making.

• Diversification and Access:

  • Provides low-cost diversification across asset classes, enhancing access to previously hard-to-reach markets for small investors.

Part 3: Various Types of ETFs

• Standard ETFs:

  • Includes full replication (for large-cap stocks) or sampling strategies (for small-cap stocks).

• Rules-based ETFs:

  • Utilizes smart beta strategies with alternative weighting based on factors like volatility and dividends.

• Active ETFs:

  • Focus on value or growth; more trading restrictions compared to mutual funds due to the in-kind creation and redemption process.

• Synthetic ETFs:

  • Constructed using swaps to replicate index returns; relies on notional exposure rather than real.

• Leveraged ETFs:

  • Utilizes swaps for leveraged returns (e.g., $2 of leverage for every $1 of investor capital).

• Inverse ETFs:

  • Designed to rise when the index falls, offering a hedge against market downturns.

• Commodity ETFs:

  • Can be physical-based, futures-based, or equity-based (stock companies linked to commodity prices).

• Covered Call ETFs:

  • Write call options to enhance yield and reduce volatility from underlying stock portfolios, with associated management constraints and variable payment structures.

Part 4: Risks of Investing in ETFs

• Tracking Error Risks:

  • Associated with fees, sampling methods, and liquidity issues.

  • Other factors include cash drag and rebalancing requirements, including currency hedging implications.

• Concentration Risk:

  • Associated with a small number of stocks comprising a large portion of ETF value.

  • Generally limited to a maximum of 10% of funds in one issuer (except for index funds).

• Securities Lending Risks:

  • Includes the risk of defaults from share borrowers and adherence to credit guidelines.

Part 5: Comparing ETFs and Mutual Funds

• Management Style:

  • ETFs are predominantly passively managed, while mutual funds are actively managed.

• Transparency and Disclosure:

  • ETFs operate with full transparency of holdings; mutual funds limit disclosure to the top 10 holdings.

• Cash Management and Flow Handling:

  • ETFs are adept at managing large infusions of cash, while mutual funds require time before investment in the market.

• Cost and Fees:

  • ETFs exhibit lower fees as they tend to be more passive; mutual funds incur higher trading expenses due to active management.

• Advisor Compensation:

  • ETF clients incur commission costs, while mutual funds may include load charges and trailer fees.

• Trade Mechanisms:

  • ETFs trade on secondary markets and can be sold short; mutual funds can only be bought and redeemed at end-of-day NAV.

• Minimum Investment Requirements:

  • ETFs can be purchased in single units without needing pre-authorized contributions; mutual funds start at $500 for PACs and SWPs.

• Liquidity Comparison:

  • ETFs depend on the liquidity of underlying shares; mutual funds are redeemed only at the end of the day at NAV per unit of the fund.

• Tax Efficiency:

  • ETFs maintain lower turnover rates and thus are generally more tax-efficient than mutual funds, which may sell units to raise cash when many are redeemed.

Part 6: Taxation of Investors

• Distribution Taxation:

  • Distributions from ETFs include dividends and interest, taxed as ordinary income.

  • Dividends from Canadian stocks benefit from a lower tax rate (dividend tax credit).

  • Capital gains from redemptions are subject to preferential treatment through the capital gains refund mechanism (CGRM).

  • Return of invested capital is non-taxable.

• Purchase and Sale Tax Implications:

  • Capital gain marked if ETF is sold above its average cost base (ACB); only 50% of this gain is taxable.

  • In-kind capital gains distribution increases an investor’s ACB, lowering potential future capital gains.

  • A capital loss occurs if the ETF is sold for less than its ACB, which can deduct from capital gains, with carryover provisions available.

Part 7: Investment Strategies

• Portfolio Construction Techniques:

  • Core and satellite portfolio approach:

  • Core holdings are passive, aimed at providing most returns.

  • Satellite holdings focus on riskier sectors to enhance returns.

• Rebalancing Strategies:

  • Ensures small allocations across domestic, international equity, and fixed income.

• Tactical Asset Allocation:

  • Utilizes ETFs for exposure to specific asset classes while exiting previous holdings.

• Cash Management Benefits:

  • ETFs allow investors to temporarily park money in the stock market.

• Accessing Niche Markets:

  • Facilitates exposure to foreign and niche markets previously hard to access.

• Tax Loss Harvesting Strategy:

  • When an ETF bought differs from an asset sold, it serves as a substitute aiding in tax loss strategies.

Part 8: Other Related Products

• Mutual Funds of ETFs:

  • Investment vehicles holding a portfolio of ETFs rather than individual stocks or bonds.

  • Can follow either a consistent asset mix or tactical approach.

• Exchange-Traded Notes (ETNs):

  • Debt obligations issued by banks paying returns based on index performance.

  • Risks include the default risk of issuers and potential call/early redemption risks from issuer.

Summary of Key Points

• Similarities Between ETFs and Index Funds:

  • Low management fees and commission-based trading (avoiding front/rear loads).

  • Experience low portfolio turnover, resulting in lower taxable capital gains alongside greater tax efficiency.

  • Priced closely to net asset value (NAV).

• Differences from Index Funds:

  • Traded on stock exchanges rather than redeemed directly with fund managers.

  • Priced throughout the trading day, not limited to closing NAV.

  • Ability to short ETFs while index mutual funds do not allow this.

• Actively Managed ETFs:

  • May focus on various investment philosophies, including value and growth.

  • Fund managers have the flexibility to deviate from benchmark indices, potentially modifying sector allocations.

  • Lower Management Expense Ratios (MERs) than comparable open-end funds, yet higher than passive ETFs.

• Leveraged ETFs:

  • Designed to deliver multiples of the index performance tracked using borrowed capital (e.g., $2 leverage for every $1 invested).

  • Example: Attempting to achieve twice the daily return of the S&P 500.

• Inverse Leveraged ETFs:

  • Structured to profit during market declines while incurring losses when the index rises.

  • Useful for hedging declining markets, utilizing swaps and short selling.

  • Example: If constructed to return -2x the S&P 500, a 10% index drop results in a 20% ETF gain.

• Commodity ETFs:

  • Designed to appreciate with an increase in specific underlying commodity prices.

  • Structured via:

  • Physical Holdings: Directly holding the commodity (e.g., gold).

  • Derivatives Usage: Employing derivatives to replicate commodity holding outcomes.

  • Equity Investment: Investing in companies involved in commodity processing or refining.